British economic analysis creates goldilocks dilemma

Goldilocks knew. The first bowl of porridge was too hot, the second too cold, but she was sure the third was right when she tasted it.

Policy makers who monitor the UK economy would like to be as decisive as Goldilocks.

They must regularly take the temperature of the economy. If it's too hot, they are considering higher interest rates and tighter government budgets to calm the game. If it's too cold, they are loosening their monetary and fiscal policies to boost consumer and business spending.

But unlike Goldilocks, government and Bank of England policy makers can not be certain.

Relying on their judgment rather than strict rules, policymakers rely on estimates of the output gap – a concept that aims to compare real gross domestic product to what it might to be if all the resources of the country were fully utilized – to decide on the state of the economy, and if it has an unused capacity.

At present, estimates of the UK output gap vary considerably, leading to very different requirements for monetary and fiscal policies.

In the spring statement of Chancellor Philip Hammond in March, for example, the UK's fiscal supervisor reported that the independent economists' estimates of the output gap for 2019 ranged from -1.7% of GDP. GDP at 0.6% for Heteronomics.

If Oxford Economics is right about the weak economy, the BoE should cut interest rates to encourage borrowing and spending, and Hammond should spend his money. But if Heteronomics' vision of an overheating economy is correct, the BoE should raise its rates and public finances would have much less room for maneuver with regard to budget largesse.

Given that the two firms' calculations are likely, it is perhaps not surprising that the 2019 output gap estimates prepared by the BoE and the Fiscal Responsibility Office are in the middle of the independent figures, suggesting that the economy is neither too hot nor too cold, with a globally balanced demand and supply.

The underlying problem facing the BoE and the OBR is that official data show that the British economy has a split personality – sluggish GDP growth and a strong labor market.

Nearly all employment indicators suggest that the economy is about to overheat. Business surveys identifying recruitment difficulties and industries facing capacity constraints are well above normal On the other hand, data on economic growth – both in surveys and official figures – are much more moderate, suggesting that there is room for improvement.

Oxford Economics and Heteronomics used similar data to draw their conclusions on the output gap. Andrew Goodwin, badociate director at Oxford Economics, said that despite the buoyancy of the labor market, unemployment could fall further without creating inflationary problems.

Philip Rush, founder of Heteronomics, said his vision of an overheated economy was partially driven by the very rapid growth in employment and by temporary factors reducing wage increases. Soon, he would expect "inflation to rise, but perhaps not just consumer price inflation – it could appear in badet prices."

According to George Buckley, economist at Nomura, many economists wonder about estimating the output gap with confusing data.

"Economists' current method of estimating output gaps is essentially to reverse their results by badyzing trends in wage growth and inflation and using their estimates from these indicators," he said. he declared.

But this strategy is risky and leaves the policy prone to big mistakes if, for example, inflation does not precisely define the economic temperature.

In 2007, Buckley noted that the International Monetary Fund estimated that the UK output gap was virtually nil. In reality, the economic structure of Britain was unsustainable and led to a financial crisis. According to the latest IMF estimates, the UK economy would overheat by 3.75% of GDP in 2007.

Regular reviews of the output gap raise fundamental questions about its usefulness as a policy tool if no one can know its real value until years later. James Smith, director of research at the Resolution Foundation, a think tank, said that with the Brexit and conflicting data signals surrounding the economy, "the degree of uncertainty regarding the The current output gap must be huge. "

However, revisions and uncertainties are far from being the only concern that policy makers rely on this concept to shape monetary and fiscal policies.

Simon Wren-Lewis, from Oxford University, has expressed his concerns about the existence of a fundamental problem in the underlying economic model of estimates of the The output gap, which will probably be even worse after a long and slow recovery.

Current techniques may well measure a gap of zero, he said, but greater demand would remain sustainable, as a considerable backlog of potentially profitable investment projects was on hold. "If demand grew in a way that seemed sustainable, companies would not increase their prices but increase their investments," he added.

Robin Brooks, an economist at the Institute of International Finance, the global body representing the financial sector, said he was concerned that the published output gaps are by nature political and often chosen to streamline existing policies rather than defining the correct rules.

He launched a "campaign against senseless production gaps" on Twitter, stressing how damaging economic policy can be if estimates of the output gap are wrong.

In the face of these fundamental concerns, it is natural to wonder why policy makers are venerating the concept.

According to Buckley, economists are sticking to the output gap because they can not imagine a better way to take the temperature of the economy. "The problem is that economists and central bankers can not abandon models based on output gaps even though they are no longer as effective as before – without some room for maneuver, you will not be able to do anything." You do not really have an economic model, "he said.